Service company valuation

As part of a large consulting contract, I was looking to acquire a security consulting firm. As my company was too small, I needed to expand. Pronto! I talked with Big Four firms (I quickly grew tired of politics), but also I talked to local boutique firms.I had found a local consulting company that communicated me an off-the-table price of EUR 2.3M (unofficial). A solid company, with a good track record and in existence over 10 years. By talking to one of the founders in confidence, and mainly by looking at public balance sheets, I learned more about the company.  They had over 25 skilled people on the payroll, costing almost EUR 1M. Background screening thought me why some shareholders wanted to sell and so forth. You know. The usual pre-due diligence information you obtain prior to opening any discussion.

Anyhow. I eventually teamed up with an investment firm that could back me up financially, while I would continue to evaluate the strategy and prepare a first official talk.

I evaluate and advise on about +30 business plans per year, so I always wonder if the proposed price brought to me (or my investors) is offered at a realistic valuation. I don’t care much about what the bidding company offers, I’m only interested at calculating a fair pricing, hence valuation…

Valuation is key

Before we begin, and strictly speaking, a consulting model is worth 12 months of consecutive profit.

A quick recon-chat with a co-founder of that company, learned the only element they consider was Face Value.  I admit, it’s a start, but I’d rather work with a more rational kind of valuation.  To me, strictly speaking, the rule of thumb for consulting company valuation is EBIT (profit of last 12 months) x 2 to 6 in a consulting business.  That’s a decent starting valuation.

In talking with colleague-investors, we quickly came to the conclusion that the face-value didn’t made any sense. So, either there is something rotten, or the selling company just have no experience whatsoever in valuations. I think it was the latter option.

So when buying a consulting company, what you actually buy at the end of the day is redundancy. You inherit a host of human capital that is directly translated in cost. Everyone that has even remotely had something to do with acquiring a consulting company knows that aligning cultures is one of the hardest things to do. It’s not uncommon for people to jump ship, air grievances that have already been in the company before you acquired it, etc. In other words, it’s a whole lot of headaches and you risk to have been buying an empty shell.

A few things I – and many investors – typically look for in a consulting firm are:

  1. Growth pattern.  Are there any long lasting relationships with clients (good value), or long-term agreements with clients (better value).  Was the growth consistent, or is the growth only recently?
  2. Personnel.  Personnel turnover rate (lower is better) and having interviews with key-persons (are they motivated or burnt-out?).  Is the staff trained, or are they juniors? Are their job packages aligned with market-rates and are the service-rates aligned with the market-rates?
  3. Products and service packages.  Is there a good balance between recycling knowledge and delivering quality as efficient as possible, or is every project delivered from scratch?  Is training part of the service?
  4. % of personnel cost vs. revenue.  Do you have a truckload of people ‘on-the-beach’ or are they working? And will I be able to keep them at work?
  5. Outstanding long-term debt. Discount this from the face value price.
  6. M&A pull from the market.  Is the company a commodity, or is the company’s services in high demand?
  7. Future proof of profitability.  Does the company has a good vision to grow the business, respond to new demands and are they taking actions; or is the company generating turnover on existing products and services? This is the future risk of the acquisition and is very important to assess this right!
  8. Acquisition vs. training of staff.  Can I quickly train staff, acquire the staff anyway (disgruntled employees can be a joy) or do I really need to acquire them?
  9. Cultural adaptibility. Will the staff accept the new working culture of mine? Consulting is a people-business and having studied some graduate colleges on human psychology, sociology, trained in the Reid interrogation techniques and advising some of my clients on psychological operations (PSYOPS), I have a pretty good feeling about people in general and specially knowing when people feel disgruntled, uneasy and when they’re about to jump ship. The risk of acquiring +25 people and having only 15 people left after the merger is somewhat of a downer 🙂 That’s why I usually negotiate an earn-out or another payout-scheme where headcount retention is a milestone.

So we thought about mitigating this risk to work with earn outs, with one of the major objectives would be personnel and client retention factors. But if we wanted to make this effective, the corrections had to be so immense that a deal like this would quickly become unacceptable for the shareholders, we thought.

Assessment criteria

My criteria are largely corresponding with the one’s of Equiteq.  Please have a look at the Slideshare from Equiteq on the eight levers to build a valuable consulting business.  Basically, the eight leve(l/r)s you are building your business on (and therefore, valuating your business) are:

  1. Market Position
  2. Sales & Profit Growth
  3. Client Relationships
  4. Quality of Fees
  5. Intellectual Property
  6. Sales and Marketing
  7. Consultant Loyalty
  8. Management Quality

Get these right, and you get a good valuation.

Anyhow.  In the end, we spent over a week thinking through our strategy, dealing with information leaks, etc. we eventually decided to drop the case to secure the major contract using a sound entrepreneurial approach: build a lean team with the customer.

Reasons why I think consulting boutiques generally suck

They just don’t scale.  I have been going about to think and ponder how to scale my consulting business before myself, and eventually came up with a few deterministic factors:

  1. Optimize daily or hourly rate (only senior and niche skills can be quoted above average to a client)
  2. Optimize efficiency of delivery (repetitive business might be boring, but it is good)
  3. Quick client servicing (cover more ground with short-term assignments, than choose a stable soil with only a few clients)

Other reasons I think consulting usually sucks? It doesn’t scale, it doesn’t scale, it doesn’t scale…  How many more reasons do you need?

A good approach would be to support consulting with long-term license renewals of hardware and training. Lots of training! But then again, then you’re an integrator, no longer a consulting company.

A good approach would be to dive into an emerging vertical where the competition is less, the chances of building intellectual property are high and the rates are higher anyway. Doing this, you become a company that’s making good money and if you (as a founder or co-founder) would have the opportunity to sell, would get a good deal.

Bottom line

Although pure-play consulting firms have a great value for customers, valuating a consulting business is a hard thing to do. For the acquirer, the acquisition is often strategic in nature (i.e. recycling the headcount and acquiring a market-share) rather than financial.

The only exit for pure-play security consulting companies is aiming to be acquired by an telecommunication incumbent, global financial institution, or a global consulting firm that is seeking to expand local activities or insource talent.